Islamic markets offer different instruments to satisfy providers and users of funds in a variety of ways: sales, trade financing, and investment. Basic instruments include cost-plus financing
(murabaha), profit-sharing (mudaraba) ,leasing (ijara), partnership (musharaka) ,and for ward sale (bay’ salam), Deferred-payment sale (bay’ mu’ajjal) and deferred-delivery sale (bay’salam) contracts, in addition to spot sales,are used for conducting credit sales. In a deferred-payment sale, delivery of the product is taken on the spot but delivery of the payment is delayed for an agreed period. Payment can be made in a lump sum or in installments, provided there is no extra charge for the delay. A deferred-delivery sale is similar to a forward contract where delivery of the product is in the future in exchange for payment on the spot market.
These instruments serve as the basic building blocks for developing a wide array of more complex financial instruments,
suggesting that there is great potential for financial innovation and expansion in Islamic financial markets
Some of the more popular instruments in Islamic financial markets are
A. Trade with markup or cost-plus sale (murabaha). One of the most widely used instruments for short-term financing is based on the traditional notion of purchase finance. The investor undertakes to supply specific goods or commodities, incorporating a mutually agreed contract for resale to the client and a mutually negotiated margin.
Around 75 percent of Islamic financial transactions are cost-plus sales.
Murabaha was originally an exchange transaction in which a trader purchases items required by an end user. The trader then sells those items to the end-user at a price that is calculated using an agreed profit margin over the costs incurred by the trader.
To be in consonance with the principles of Islamic finance governing exchange transactions every murabaha transaction must meet the following conditions:
Murabaha transactions may be undertaken only where the client of a bank, or financial institution, wants to purchase a commodity.
This type of transaction cannot be effected in cases where the client wants to get funds for a purpose other than purchasing a commodity, like payment of salaries, settlement of bills or other liabilities.
To make it a valid transaction it is necessary that the commodity is really purchased by the bank and it comes into the ownership and possession (physical or constructive) of the bank so that it may assume the risk of the commodity so far as it remains under its ownership and possession.
After acquiring the ownership and possession of the commodity it should be sold to the client through a valid sale.
Some quarters have equated murabahah transactions to interest-based loans. However, there are many significant factors that distinguish a murabaha contract from a riba-based one. Some of them are the following:
In the event of default by the end user, the financer only has recourse to the items financed, and no further mark-up or penalty may be applied to the sum outstanding. This means that the amount to be repaid does not go on increasing with passage of time as in the case of amounts borrowed from conventional banks on interest.Also, in conventional financing, the bank gives loans to its clients without ever being concerned how the money is being put to use.
In the event of a murabahah transaction, no money is loaned to the client. Rather, the financing party purchases the goods himself, based on the requirement of the client. This ensures that financing is always asset-based. In effect, this type of financing creates real assets and inventories.
Another major difference between a murabahah contract and an interest-based one is that the financier cannot be unconcerned about the purposes for which the asset being leased is to be put to use. Conventional banks have no compunction in lending to gambling houses or liquor companies, or even pornographic filmmakers.
Islamic principles of finance are based on a well-established rule which dictates that “The benefit of a thing is a return for the liability for loss from that thing”. Hence, in a murabahah transaction the bank or financier assumes the risk by purchasing the commodity before he sells it at a markup.
This mark up is considered as the reward of the risk he assumes.
Interest-bearing loans assume no risks whatsoever. In other words, because the bank takes title to the goods, and is therefore engaged in buying and selling, its profit derives from a real service that entails a certain risk. This aspect lends the transaction legitimacy.
Most scholars have ruled that, to serve as a deterrent to such as may willfully delay payments, the financer may get the buyer to agree, at the time of the contract, to make a pre-specified donation to an agreed charity in case of late payment of monthly installments.
These scholars, however, caution that this device should be used to the minimum extent and only in cases where musharakah or mudarabah are not practicable for one reason or another.
B. Profit-sharing agreement (mudaraba). This is identical to an investment fund in which managers handle a pool of funds. The agent-manager has relatively limited liability while having sufficient incentives to perform. The capital is invested in broadly defined activities, and the terms of profit and risk sharing are customized for each investment. The maturity structure ranges from short to medium term and is more suitable for trade activities.
Mudaraba implies a contract between two parties whereby one party, the rabb al-mal (beneficial owner or the sleeping partner), entrusts money to the other party called the mudarib (managing trustee or the labour partner). The mudarib is to utilize it in an agreed manner and then returns to the rabb al-mal the principal and the pre-agreed share of the profit. He keeps for himself what remains of such profits.
The following rules must govern all Mudaraba transactions:
• The division of profits between the two parties must necessarily be on a proportional basis and cannot be a lump sum or guaranteed return.
• The investor is not liable for losses beyond the capital he has contributed. The mudarib does not share in the losses except for the loss of his time and efforts.
• Briefly, an Islamic bank lends money to a client to finance a factory, for example, in return for which the bank will get a specified percentage of the factory's net profits every year for a designated period. This share of the profits provides for repayment of the principal and a profit for the bank to pass on to its depositors. Should the factory lose money, the bank, its depositors and the borrower all jointly absorb the losses, thereby putting into practice the pivotal Islamic principle that the providers and users of capital should share risks and rewards.
Islamic banks use this instrument to finance those seeking investments to run their own enterprises or professional units, whether they be physicians or engineers or traders or craftsmen.
The bank provides the adequate finance as a capital owner in exchange of a share in the profit to be agreed upon.
It is worth noting that this mode is a high risk for the bank because the bank delivers capital to the mudarib who undertakes the work and management and the mudarib shall only be a guarantor in case of negligence and trespass. Islamic banks usually take the necessary precautions to decrease the risk and to guarantee a better execution for the mudaraba and pursue this objective with seriousness.
However, it may be noted that, under mudarabah, the liability of the financier is limited to the extent of his contribution to the capital, and no more.
C. Equity participation (musharaka). This is analogous to a classical joint venture. Both entrepreneur and investor contribute to the capital (assets, technical and managerial expertise, working capital,
etc.) of the operation in varying degrees and agree to share the returns (as well as the risks) in proportions agreed to in advance.
Traditionally,this form of transaction has been used for financing fixed assets and working capital of medium- and long-term duration.
Musharaka is a partnership, normally of limited duration, formed to carry out a specific project.
It is, therefore, similar to a Western-style joint venture, and is also regarded by some as the purest form of Islamic financial
instrument, since it conforms to the underlying partnership principles of sharing in, and benefiting from, risk. Participation in a musharaka can either be in a new project, or by providing additional funds for an existing one. Profits are divided on a pre-determined basis, and any losses shared in proportion to the capital contribution. In this case, the bank enters into a partnership with a client in which both share the equity capital- and maybe even the management -of a project or deal, and both share in the profits or losses according to their equity shareholding. There are two basic types of musharaka:
i. Sharikah al milk: partnership based on joint ownership. This may be voluntary e.g. in the purchase of a ship, or involuntary e.g. as a result of inheritance.
ii. Sharikah al uqud: partnership based on a contractual relationship.
There are five subdivisions:
1. Sharikat al Mufawadah (full authority and obligation): a limited partnership with equal capital contributions, responsibility, full authority on behalf of others, and responsibility for liabilities,incurred through the normal course of business.
2. Sharikat al Inan (restricted authority and obligation): a limited partnership with unequal capital contributions. They do not share equal responsibility, and this reflects their share of the profits.
3. Sharikat al Wujuh (goodwill /credit worthiness): companies based on the reputation of one or both parties, typically small scale business.
4. Sharikat al Abdan (labour, skill and management): a company based on the contribution of human efforts, no capital contributions, again, typically small scale business.
5. Sharikat al Mudaraba: a mudaraba
D. Leasing (ijara). Another popular instrument, accounting for
about 10 percent of Islamic financial transactions, is leasing.
Leasing is designed for financing vehicles, machinery, equipment, and aircraft.
Different forms of leasing are permissible, including leases where a portion of the installment payment goes toward the final purchase (with the transfer of ownership to the lessee).
Ijarah can be defined as a process by which " usufruct of a particular property is transferred to another person in exchange for a rent claimed from him/her". In many respects, Ijarah resembles leasing as it is practiced in today’s commercial world.
The distinguishing feature of this mode is that the assets remain the property of the Islamic bank to put them up for rent every time the lease period terminates so as not to remain unutilized for long
periods of time. Under ijarah the bank or the leasing company assumes the risk of recession or diminishing demand for these assets.
To be in consonance with the principles of Islamic finance governing financial transactions every ijarah transaction must meet the following conditions:
• It is a condition that the object leased must not be perishable or consumable.
• The lease is for the utilization not the consumption of the asset.
• It is a condition that the subject of the contract must actually and legally be attainable. It isnot permissible to lease something that cannot be delivered.
• The lessee must ensure that the asset is used for the purpose it is made for. The lessee shallcomply with the provisions of the contract. The lessee also shall not benefit from the asset in a way more than what has been agreed upon.
• It is not permitted to lease real estate to be used as an interest based bank or a bar. However it is permissible to lease property to those whose major activities are permissible or halal even if they include some secondary prohibited practices.
• The lessor must not only deliver the asset on time, on the date of commencement of lease, but also ensure that the lessor delivers those accessories as well which are essential for the lessee to benefit from the asset as per the norms.
• The lease contract must state the lease period clearly.
Renewal terms must also be stated clearly, and things like the rentals for all subsequent years, after the first year, should not mention clauses like ‘left to the sole discretion of the lessor’ and the like.
• The rental must be money. The lease rent falls due from the receipt of the asset by the lessee,not the date the contract is signed.
• The amount and timing of the lease payments should be agreed in advance. However, theagreed schedule and amount of those payments need not be uniform.
• It is permissible for the two parties to agree during the lease period to review the lease period or the rental or both. That is because the lease contract occurs periodically unlike the sale contract where the transfer of ownership is immediate.
• The lessor bears the liabilities when leasing the asset such as damage to the asset, payment of premium cost and basic maintenance.
• There is no objection to authorizing the lessee to undertake all the above but the costs thereof must be borne by the lessor/owner.
• The lessor/owner bears all the costs of the legally binding basic maintenance and these are operations on which the permanence and suitability of the leased object depend. The lessor also bears the cost of the replacement of durable parts. However, it is permissible to make the lessee bear the cost of ordinary routine maintenance, because this cost is normally known and can be considered as part of the rental.
• The conditions of usage of the leased items must be stated.
The lessor must have full possession and legal ownership of the asset prior to leasing it.
• A price cannot be pre-determined for the sale of the asset at the expiry of the lease. However,lessor and lessee may agree to the continuation of the lease or the sale of the leased asset to the lessee under a new agreement at the end of the initial lease period.
• In the event of late payment of rental, the Ijarah may be terminated immediately.
• The lessor may claim compensation for any damage caused to the leased assets as a result of negligence on the part of the lessee.
Literally, Ijarah means to give something on rent. As a term of Islamic Fiqh, Ijarah can also refer to wages paid to a person in consideration of the services rendered by him/her. In the above discussion, the term Ijarah is used to represent the usufructs of assets and properties, and not to the services of human beings.
E. Salam is one of the basic conditions for the validity of sale in Shariah that the commodity intended to be sold must be in the physical or constructive possession of the seller. This condition has three implications:
First, the commodity must be existing; a commodity that does not exist at the time of sale cannot be sold.
Second, the seller should have acquired the ownership of that commodity. If the commodity exists but the seller does not own it, he cannot sell it to anybody.
Third, mere ownership is not enough. It should have come in the possession of the seller, either physically or constructively. If the
seller owns a commodity, but he has not acquired its delivery by himself or through an agent, he cannot sell it.
There are only two exceptions to this general principle in Shariah.
One is Salam and the other is Istisna.
Both are sales of a special nature.
Salam, or Bay-Salaam as it is also called, is a sale whereby the seller undertakes to supply some specific goods to the buyer at a future date in exchange for an advanced price fully paid on the spot.
Here the price is paid in cash, but the supply of the purchased goods is deferred. The buyer is called "Rabb-us-Salam", the seller is "Muslam ilaih", the cash price is "ra's-ul-mal", and the purchased commodity is termed as "muslam fih".
The Shariah allows Salam subject to certain conditions. The basic purpose of this sale was to meet the needs of the small farmers who needed money to grow their crops and to feed their family up to the time of their harvest. After the prohibition of riba they could not take usurious loans. Therefore, it was allowed for them to sell the agricultural products in advance.
Similarly, the traders of Arabia used to export goods to other places and to import other goods to their homeland. They needed money to undertake this type of business. They could not borrow from the usurers after the prohibition of riba. It was, therefore, allowed for them that they sell the goods in advance. After receiving their cash price, they could easily undertake the aforesaid business. Salam was beneficial to the seller, because he received the price in advance, and it was beneficial to the buyer also,because normally, the price in Salam used to be lower than price in spot sales.
The permissibility of Salam was an exception to the general rule that prohibits forward sales. Therefore,it was subjected to some strict conditions.
Conditions of Salam:
It is necessary for the validity of Salam that the buyer pays the price in full to the seller at the time of effecting the sale. This is necessary because in the absence of full payment by the buyer,it will be tantamount to a sale of debt against debt, which is expressly prohibited. Moreover, the basic wisdom behind the permissibility of Salam is to fulfill the instant needs of the seller. If the price is not paid to him in full, the basic purpose of the transaction will be defeated.
Salam can be effected in those commodities only whose quality and quantity can be specified exactly. The things whose quality or quantity is not determined by the specification cannot be sold through the contract of Salam. For example, the precious stones
cannot be sold on the basis of Salam, because every piece of precious stones is normally different from the other either in its quality or in its size or weight and their exact specification is not generally possible.
Salam cannot be effected on a particular commodity or on a product of a particular field or farm.
For example, if the seller undertakes to supply wheat of a particular field, or the fruit of a particular tree, the Salam will not be valid, because there is a possibility that produce of that particular field or the fruit of that tree is destroyed before the delivery, and in the presence of this possibility the delivery remains uncertain. The same rule is applicable to every commodity whose supply is not certain. It is necessary that the quality of the commodity (intended to be purchased through Salam) be fully specified leaving no ambiguity that may lead to dispute. All the possible details in this
For example, if the seller undertakes to supply wheat of a particular field, or the fruit of a particular tree, the Salam will not be valid, because there is a possibility that produce of that particular field or the fruit of that tree is destroyed before the delivery, and in the presence of this possibility the delivery remains uncertain. The same rule is applicable to every commodity whose supply is not certain. It is necessary that the quality of the commodity (intended to be purchased through Salam) be fully specified leaving no ambiguity that may lead to dispute. All the possible details in this